US Equities: Pivot to Quality and Income
#Market Strategy — 05.08.2021

Pivot to Quality and Income

US Equity Perspectives, August 2021

Alexis Tay, Senior Adviser Equity Advisory Asia

SUMMARY

Why position in Quality stocks?

We currently favor a more defensive sector stance, with a bias towards Quality and Income, as we expect the upcoming summer months to likely be more volatile as investors digest uncertainties around inflation, tapering, peak growth, and taxes.

Over-the-top Fed monetary policy and generous government fiscal backstop have underpinned “risk-on” sentiment and the relative performance of Low Quality stocks since the pandemic struck early last year. Today, Low Quality stocks trade at the widest valuation premium as compared to High Quality stocks in over a decade.

With peak liquidity in view (tapering likely to be announced in the coming months and begin in early 2022), we think there is room for High Quality stocks’ performance to play catch up, judging from historical precedence. In prior tapering periods, High Quality stocks outperformed Low Quality stocks >60% of the time over 3-6 months.

Other than peak liquidity, peaking profit growth also falls in favor of Quality. Consensus estimates for S&P 500 Index earnings growth is 33%/11% for 2021/2022 respectively. While earnings growth for 2022 is still healthy, it is still a significant deceleration from the previous year. Higher Quality stocks have historically outperformed when profits decelerate.

Quality, as defined by low earnings and dividend volatility, is not necessarily synonymous with low beta and defensive stocks. Over the last decade we have seen a substantial increase in Quality stocks within the Technology, Real Estate and Financials sectors.

US banks –Banking on a strong 2H

The “Big Six” US banks have all reported quarterly results and have provided insights around the health of the sector and the economy. The sector remains a good leveraged way in which to play a macro recovery, with the recent pullback offering opportunities.

The big banks all beat EPS estimates, driven by lower loan loss provisions. Main positives gleaned from 2Q results include lower provisioning for bad debt, strong investment banking trends, and robust card volumes. On the other hand, loan growth remains lackluster, net interest income faces some pressure from low interest rates, and trading volumes have decelerated. 

Cybersecurity: unprecedented threat environment drives strong demand

Within the software space, we like cybersecurity names with reasonable valuations and robust fundamental backdrop.   Better-than-expected 1Q21 results, improving vendor commentary and a recent cybersecurity industry conference showed strong signs of rising security demand in 2021, as companies grapple with the rapid shift to Cloud and Remote Computing post-Covid, as well as the  rising incidence and sophistication of cyberattacks. According to a Morgan Stanley research report in May 2021, it also suggests stronger bookings in April/May 2021, while yoy compares get easier ahead, creating a favorable setup into 2Q21 results.

Our CIO’s view currently favors a more defensive sector stance, with a bias towards Quality and Income, as we expect the upcoming summer months to likely be more volatile as investors digest uncertainties around inflation, tapering, peak growth, and taxes.

Why position in Quality stocks?

Over-the-top Fed monetary policy and generous government fiscal backstop have underpinned “risk-on” sentiment and the relative performance of Low Quality stocks to High Quality stocks since the pandemic struck early last year.

Low Quality stocks have been among the standout performers over the past 12+ months, outpacing the S&P 500 Index by 26% since the end of March 2020, and that momentum has been carried into the first 5 months of 2021. Today, Low Quality stocks trade at the widest valuation premium as compared to High Quality stocks in over a decade.

In this piece, we reference S&P’s Quality rankings, where a letter grade is assigned to a company based on a variety of factors, chief among them is the consistency of earnings and dividend growth over the past 10 years. Quality rankings of B+ or better represent High Quality stocks, while quality rankings of B and below represent Low Quality stocks.

With peak liquidity in view (tapering likely to be announced in the coming months and begin in early 2022), we think there is room for High Quality stocks’ performance to play catch up, judging from historical precedence. In prior tapering periods, High Quality stocks outperformed Low Quality stocks >60% of the time over 3-6 months (Chart 1).

Other than peak liquidity, peaking profit growth also falls in favor of Quality stocks.

Consensus estimates for S&P 500 Index earnings growth is 33%/11% for 2021/2022 respectively. While earnings growth for 2022 is still healthy, it is still a significant deceleration from the previous year. 

Read US Equities Perspectives, July edition:  Finally, a Corporate Capex Pickup?

us quality performance

Peak profit growth should benefit Quality, as profit growth is now scarcer and investors tend to pay up for stable earnings growth. Higher Quality stocks have historically outperformed when profits decelerate (Chart 2). 

s and p 500

What is Quality today?

Quality, as defined by low earnings and dividend volatility, is not necessarily synonymous with low beta and defensive stocks.

In fact, cyclicals today have near record low earnings volatility relative to defensive sectors, with the percentage of High Quality companies within Russell 1000 Value Index crossing above Russell 1000 Growth Index for the first time since 2009. Interestingly, ESG (environmental, social and governance) factors have also been found to be excellent signals for future earnings risk.

Over the last decade we have seen a substantial shift in sector composition of stocks rated B+ or higher. Technology, Real Estate and Financials sectors have seen the biggest increase in Quality stocks going by number of companies while Consumer Discretionary and Consumer Staples have been declining in Quality stocks since 2017 and the proportion of High Quality stocks is near record lows (Chart 3). 

us historical average

In terms of broad observations across the big US banks:

Main positives:

  • Lower provisioning for bad debt. This suggests an improving credit picture. Lower credit losses are allowing banks to release more of the reserves previously put aside for bad debt.
  • Investment banking. M&A advisory and underwriting were robust, thanks to mergers and acquisitions (M&A), new listings (IPOs and SPACs) and general post-pandemic capital raising.
  • Credit card volumes were robust on increased usage as consumers started spending. A major bank noted consumers spent at a 22% higher rate year-to-date vs 1H 2019. That said, credit card balances are also being paid off faster than usual, due to consumers holding more cash.
  • Optimistic 2H21 outlook with pace of global recovery exceeding earlier expectations and with consumer and corporate confidence rising.

Less supportive:

  • Loan growth was weaker across most banks due to excess liquidity from high savings rates and stimulus in the system.
  • Net interest income saw some pressure from low interest rates, hurting those that are most rate sensitive.
  • Trading volumes decelerated, principally driven by weaker fixed income trading. Equity trading was generally robust.
  • Non-interest expenses are inching up.

Cybersecurity: unprecedented threat environment drives strong demand

Within the software space, we like cybersecurity names with reasonable valuations and robust fundamental backdrop. 

Better-than-expected 1Q21 results, improving vendor commentary and a recent cybersecurity industry conference showed strong signs of rising security demand in 2021.

Drivers of this strength include:

  • The industry is still catching up to a rapid shift to Cloud and Remote Computing during the height of the pandemic last year, which has significantly expanded the attack surface area and increased complexity for organizations.
  • An unprecedented threat environment, with a significant rise in both frequency and sophistication of cyberattacks over the past year. Recent incidents such as the Colonial Pipeline hack also highlight the rising cost of cybercrime via ransomware attacks, where the average cyber ransom paid by targets more than doubled to >US$312K in 2020, according to data from Palo Alto Networks, a key cybersecurity provider. Attacks on critical infrastructure also raise growing economic and national security concerns, prompting a recent US Presidential executive order on cybersecurity.
  • Larger and more strategic enterprise deals are coming into fruition as CIOs re-evaluate their existing security architectures for an evolving threat landscape. 

Despite what's typically a seasonally slower quarter, 1Q21 results came in much stronger than expected. According to a Morgan Stanley research report in May 2021, it also suggests stronger bookings in April/May 2021, while yoy compares get easier ahead, creating a favorable setup into 2Q21 results.

Cybersecurity is also becoming a more important metric in the ESG framework following recent data breach incidents.

Companies can be fined and/or suffer reputational damage if they do not adequately protect their information networks. Meanwhile, over the past few years, more regulations on data security have been introduced globally to enhance protection of personal information and reshape corporate behavior on data usage and security, e.g. General Data Privacy Regulation  (GDPR) in Europe, and California Consumer Privacy Act (CCPA) in the US.  

We expect cybersecurity software companies to benefit from investor interest in this space as security becomes a more visible ESG topic. 

CONCLUSION/STRATEGY

We currently favor a more defensive sector stance, with a bias towards Quality and Income, as we expect the upcoming summer months would likely be more volatile as investors digest uncertainties around inflation, tapering, peak growth, and taxes. We continue to like US Banks for their quality and income attributes, and the sector remains a good leveraged way in which to play a macro recovery. Within the software space, our preference stays with cybersecurity names with reasonable valuations, a robust fundamental backdrop, and positive set-up into 2Q earnings.